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Bank Loan Covenants
Loan covenants are contractual restrictions placed on a borrower by a lender. In effect, these covenants are the borrower's promise about what action they will or will not take while the loan is out standing. Loan covenants help the bank to ensure that any company to which a loan is made has adequate liquidity to make principal and interest payments on the outstanding loan as they come due. Negotiating loan covenants is, in effect, a tug of war. The lender wants to avoid covenants that restrict their freedom of action. The bank wants certain assurances that the debtor will act in a way that helps ensure the loan can and will be paid on time.
There are two types of covenants:
- Affirmative and
- Negative or Restrictive Covenants
An affirmative covenant requires a borrower to meet certain standards such as providing the lender with financial updates at regular intervals. A negative or restrictive covenant is one that constrains or limits the actions the debtor can take. The borrower is also typically required to provide the lender with periodic updates about their financial condition. Covenants relating to financial statements and financial ratios are called financial covenants. Generally, financial covenants require the borrower to meet certain minimum levels of financial performance in addition to:
- Paying taxes, fees and licenses as they come due;
- A requirement that the borrower provides the lender with periodic financial statement updates;
- A requirement that the borrower make interest and principal payments on time;
- A requirement that the borrower maintains specific financial ratios relating to liquidity, profitability and amount of financial leverage;
- Limitations on additional loans from other sources;
- Conditions or restrictions on dividends issued to stockholders
© 2010 by Michael C. Dennis. All Rights Reserved.